Economic: foundations and

models - Notes
Economics is the study of how society manages its
scarce resources.
For example:
Economics helped Jing to understand the
production, consumption and transfer of wealth.
Key Economic Ideas
• People are rational.
• People face tradeoffs.
• The cost of something is what you give up to get
it.
• Rational people think at the margin.
• People respond to incentives.
Forces and Trends
 • The forces and trends that affect how the
economy as a whole works.
– The standard of living depends on a
country’s production.
– Prices rise when the government prints too
much money.
– Society faces a short-run tradeoff between
inflation and unemployment.
People are rational
Economists generally assume that people are
rational.
• This assumption does not mean that
economists believe that everyone knows
everything or always makes the ‘best’ decision.
• It means that consumers and firms use as much
of the available information as they can to
achieve their goals.
People Face Tradeoffs
• Scarcity creates trade-offs.
  How do you divide your time between studying
different subjects? Or between work, hanging
out with friends and sleeping in?
 How does your family divide its income
between housing, food, clothing and
entertainment?
 How does the government divide its revenue
between education, health care, infrastructure
and emergency services?
People Face Tradeoffs
Making decisions requires trading off
one goal against another.
Efficiency vs Equity
• Efficiency means society gets the most that it
can from its scarce resources.
For example, taxpayers want to see their tax
dollars spent efficiently.
 • Equity means the benefits of those resources
are distributed fairly among the members of
society.
For example, taxation can be used to
redistribute wealth from rich households to poor
households, thereby increasing equity.
Efficiency vs Equity
• Most societies value both efficiency and equity.
• Unfortunately, there is often a trade-off
between these two goals.
For example
Funding public education and health care
requires the government to raise taxes. But taxes
reduce the reward for working hard and being
successful, leading to a loss of efficiency.
Efficiency vs Equity
• Productive efficiency occurs when a good or
service is produced using the least amount of
resources.
 • Allocative efficiency occurs when
production reflects consumer preferences
and resources are allocated throughout the
economy to produce what consumers
demand.
Efficiency vs Equity
• Dynamic efficiency occurs when new
technologies and innovation are adopted over
time. Markets tend to be efficient because they
promote competition and facilitate voluntary
exchange.
• Voluntary exchange refers to the situation in
which both the buyer and seller of a product
are made better off by the transaction.
The Cost of Something Is
What You Give Up to Get It.
• Decisions require comparing costs and benefits
of alternatives.
– Whether to go to college or to work?
– Whether to study or go out on a date?
 – Whether to go to class or sleep in?
The Cost of Something Is
What You Give Up to Get It.
• The opportunity cost of an item is what you
give up to obtain that item.

For example:
My opportunity cost of sitting through this
lecture is reading a book and enjoying an espresso
at a local café.
Rational people think at the margin
• Marginal change is a small incremental
adjustment to a plan of action.
– Marginal benefit is the benefit created by a
marginal change.
– Marginal cost is the cost created by a
marginal change.
Rational people think at the margin
People make decisions by comparing costs and
benefits at the margin.
Rational people think at the margin
• An example of an all-or-nothing decision is
‘Should I sleep or stay up all night?’
• An example of a marginal decision is:
‘Should I get out of bed now, or press the snooze
button and sleep in for another 10 minutes?’
Rational people think at the margin
• Rational people often make decisions by
comparing the marginal benefit of an action
with the marginal cost.
• The decision to choose one alternative over
another occurs when that alternative’s marginal
benefits exceed its marginal costs!
Centrally Planned Economy
• A society can have a centrally planned economy
in which the government decides how
economic resources will be allocated.
Market Economy
• A market economy is an economy that allocates
resources through the decentralised decisions
of many firms and households as they interact
in markets for goods and services.
– Households decide what to buy and who to
work for.
– Firms decide who to hire and what to
produce.
Market Economy
• Firms and households interact in the
marketplace, where prices and self-interest
guide their decisions.
• All the high-income democracies, such as
Australia, the USA, Canada, Japan and many
European countries, are in large part market
economies.
Mixed Economy
• A mixed economy is an economy in which most
economic decisions result from the interaction
 of buyers and sellers in markets, but in which
the government plays a significant role in the
allocation of resources.
The invisible hand
• The invisible hand concept was proposed by
Adam Smith in An Inquiry into the Nature and
Causes of the Wealth of Nations (1776).
The invisible hand
• The invisible hand is the idea that buyers and
sellers freely interacting in a market economy
will create an outcome that allocates goods and
services to those people who value them most,
and will make the best use of scarce resources.
The invisible hand
• Within a market economy, prices are the
instrument with which the invisible hand directs
economic activity.
• In any market, buyers look at the price when
determining how much to demand, and sellers
 look at the price when deciding how much to
supply.
The invisible hand
• Smith’s great insight was that prices adjust to
guide buyers and sellers to reach outcomes that
can maximise society’s wellbeing as a whole.
• When the government prevents prices from
adjusting naturally to supply and demand, it
impedes the invisible hand’s ability to
coordinate the millions of households and firms
that make up the economy.
Externality
• Externality is a consequence of an economic
activity that is experienced by unrelated third
parties. An externality can be either positive or
negative.
• A positive externality makes the bystander
better off.
• A negative externality makes the bystander
worse off.
Externality
• A positive externality makes the bystander
better off.
For example:
 A farmer who grows apple trees provides a
benefit to a beekeeper. The beekeeper gets
a good source of nectar to help make more
honey.
 If you walk to work, it will reduce
congestion and pollution, benefiting
everyone else in the city.
Externality
• A negative externality makes the bystander
worse off.

For example:
 If you play loud music at night your
neighbour may not be able to sleep.
  If you drive a car, it creates air pollution and
contributes to congestion. These are both
external costs imposed on other people who
live in the city.
Market Power
• Market power is the ability of a single economic
actor (or small group of actors) to have a
substantial influence on market prices.
For example:
A monopoly can earn substantial profits by
exercising its market power.
Productivity
• Productivity is the quantity of goods and
services produced from each hour of a worker’s
time.
For example:
Is usually expressed as a ratio of output to inputs. It
can be expressed as units of a product (e.g. cars) per
worker-hour (total number of hours worked by all
workers on that car). Given the cost of the worker-
hour, productivity can also measure the efficiency of
a company.
Inflation
• Inflation is an increase in the overall level of
prices in the economy.
• In most cases of large or persistent inflation, the
culprit turns out to be the growth in the
quantity of money.
• When a government creates large quantities of
the nation’s money, the value of the money
falls.
Economic Models
• Economists rely on economic theories or
models to analyse real-world issues.
• Economists try to approach problems with a
scientist’s objectivity.
• Observations inspire economic theory. In turn,
economic theory is tested by comparing
theoretical predictions against data gathered in
the real world.
Economic Models
• Economists use economic models to answer
questions.
For example
How do we deal with water scarcity in Australia?
The role of assumptions in economics
• Any model is based on making assumptions
because models have to be simplified to be
useful.
• Using assumptions we can construct economic
models to learn about the world.
Hypotheses in Economic Models
• A hypothesis in an economic model is a
statement that may either correct or incorrect
about an economic variable.
• Economic Variables is something measurable
that have different values (e.g. wages, prices,
litres of water).
Hypotheses in Economic Models
For example:
An example of a hypothesis in an economic model is
the statement that ‘charging more for water will
lead to a decline in water usage’.
• An economic hypothesis is usually about a
casual relationship; in this case, the hypothesis
states that a higher water price causes or leads
to, reduced amounts of water usage.
Economic Variables
• Economists accept and use an economic model
if it leads to hypotheses that can be confirmed
by statistical analysis.
Positive Analysis
• Positive Analysis is statements that can be
checked by using the facts.
For example:
“A reduction on taxation rates will lead to an
increase in spending by individuals”
 – It is a positive statement and can be
confirmed or negated by factual data.
Normative Analysis
• Normative Analysis are claims that attempt to
prescribe how the world should be.
For example:
“Individuals should receive reductions in taxation as
they are able to decide how to spend money to
maximise their satisfaction better that the
government”
– It is a normative statement as it cannot be
tested.
Economics
• Economics is about positive analysis, which
measures the costs and benefits of different
courses of action.
Microeconomics
 • Microeconomics is the study of how households
and firms make decisions and how they interact
in markets.
For example:
Microeconomics focuses on individual markets,
examining how incentives and trade-offs influence
buyer and seller behaviour.
Macroeconomics
• Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment
and economic growth.
For example:
The setting of monetary policy depends primarily on
macroeconomic factors.
Chapter 2

Choices and Trade-offs in the Market

Learning Outcomes
After studying this chapter you should be able to:
 • Use a production possibility frontier to analyse
opportunity costs and trade-offs.
• Understand comparative advantage and explain
how it is the basis for trade.
• Explain the basic idea of how a market system
works.
• Understand why property rights are necessary
for a well-functioning market.
Production Possibilities Frontier
• The production possibilities frontier (PPF) is a
curve that the maximum attainable
combinations of two products that may be
produced with available resources.
Production possibilities frontier
Increasing Marginal Opportunity Cost
• It is an economic concept where the more
resources already devoted to an activity, the
smaller the payoff to devoting additional
resources to that activity.
Increasing Marginal Opportunity Cost
Economic Growth
• At any given time the total resources available
to any economy are fixed.
– For example: if Australia produces more
computers it must produce less of
something else – televisions in our example.
• Over time, though, the resources available to an
economy may increase.
• For example: The amount of available
labour force and the capital stock shifts
the production and makes it possible to
produce both more computers and
more television.
Trade
 • Trade is the act of buying or selling a good or
service in a market.
For example:
We sell our labour services as, say, an
accountant, salesperson or nurse for money, and
then use the money to buy goods and services.
• Therefore, they are trading their services for
food, clothing and other goods and services.
Trade
• One of the great benefits of trade is that it
makes it possible for people to become better
off by increasing both their production and their
consumption.
Absolute Advantage
• Absolute advantage is the ability of an
individual, firm or country to produce more of a
good or service than competitors using the
same amount of resources.
Comparative Advantage
 • Comparative advantage is the ability of an
individual, firm or country to produce a good or
service at a lower opportunity cost than other
producers.
Market Systems
• Market is a group of buyers and sellers of a
good or service and the institution or
arrangement by which they come together to
trade.
• Product Market markets for goods – such
as computers – and services – such as
medical treatment.
Market Systems
• Factor Market it is related to the markets in
which these factors are traded such as labour
market, capital market, resources market, and
so on.
• Factors of production are the inputs used to
make goods and services.
Price Mechanism
 • Price Mechanism is the system in a free market
where price changes lead to producers changing
production in accordance with the level of
consumer demand.

Legal Basis of a Successful Market System

• In a free market government does not restrict
how firms produce and sell goods and services,
or how they employ factors of production, but
the absence of government intervention is not
enough for the market system to work well.
• Government has to provide secure rights to
private property for the market system to work
at all.